Monopoly Power and Endogenous Variety in Dynamic Stochastic General Equilibrium: Distortions and Remedies

We study the e¢ ciency properties of a dynamic, stochastic, general equilibrium, macroeco- nomic model with monopolistic competition and …rm entry subject to sunk costs, a time-to-build lag, and exogenous risk of …rm destruction. Under inelastic labor supply and linearity of produc- tion in labor, the market economy is e¢ cient if and only if symmetric, homothetic preferences are of the C.E.S. form studied by Dixit and Stiglitz (1977). Otherwise, e¢ ciency is restored by properly designed sales, entry, or asset trade subsidies (or taxes) that induce markup synchro- nization across time and states, and align the consumer surplus and pro…t destruction e¤ects of …rm entry. When labor supply is elastic, heterogeneity in markups across consumption and leisure introduces an additional distortion. E¢ ciency is then restored by subsidizing labor at a rate equal to the markup in the market for goods. Our results highlight the importance of preserving the optimal amount of monopoly pro…ts in economies in which …rm entry is costly. Inducing marginal cost pricing restores e¢ ciency only when the required sales subsidies are …nanced with the optimal split of lump-sum taxation between households and …rms.